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How interest capitalization works on student loans

Deferment, forbearance and income-driven repayments might cost you more than you expected.

Updated

Holding off on student loan repayments while you’re in school or when you hit a financial rough patch might sound attractive. And income-driven repayments could be a good deal. But thanks to interest capitalization, your loans can be more expensive in the long, and short term. This sneaky expense increases how much you pay monthly and in overall interest.

What is interest capitalization on student loans?

Interest capitalization is when the lender adds any unpaid interest to your loan balance. For example, if you deferred a $10,000 student loan for three months and $85 in interest added up while your repayments were paused, your balance would be $10,085 after interest capitalization.

This generally happens if you weren’t making full interest payments and made a change to your repayment plan.

How does interest capitalization affect the cost?

Interest capitalization affects both the short- and long-term cost of your student loans.

Higher total loan cost

Interest capitalization increases your loan balance when the unpaid amount gets added to the principal. Since interest is a percentage of your loan balance, having a higher loan balance increases your interest payments. With interest capitalization, you end up paying interest on interest.

Higher monthly repayments

In most cases, pausing your loan repayments typically doesn’t lengthen your loan term. So even without interest capitalization, you’d have to pay off the same amount in a shorter timeframe. But because interest capitalization increases your balance, you’ll have to pay even more than you owed before over a shorter period of time.

Other costs related to interest capitalization

Pausing or making reduced repayments makes your loan more expensive, even without interest capitalization. This is because interest is based on your loan balance. As your balance decreases, so does your interest payments. If your balance stays the same or decreases at a slower rate, you’ll pay more in interest.

What triggers interest capitalization?

Interest capitalization can happen in the following situations:

  • After your grace period on private and unsubsidized federal loans. Unless you were making repayments on interest while you were in school, the interest that added up during your grace period gets added to your loan principal. Direct Subsidized Loans are the one exception.
  • Deferment on private and unsubsidized federal loans. If you pause your student loan repayments, interest continues to add up unless you have a Direct Subsidized Loan. That interest capitalizes once you start making full repayments again.
  • Forbearance on all student loans. Forbearance works a lot like deferment. The difference is that interest capitalizes on all loans, even Direct Subsidized Loans.
  • Voluntarily leave the PAYE, REPAYE or IBR Plan. If you’re enrolled in any of these income-driven repayment (IDR) plans, any interest you didn’t pay gets capitalized.
  • Fail to recertify income while on the REPAYE, PAYE or IBR Plan. If you don’t make the deadline to submit updated income information on any of these plans, your interest also gets capitalized.
  • Lose eligibility for the IBR or PAYE Plan. Interest also capitalizes if your income is too high or you otherwise lose eligibility for these repayment plans.

How does this work? Let’s take a look at an example …

Say you had a $20,000 Direct Subsidized Loan and a $20,000 Direct Unsubsidized Loan at a 5% interest rate. You took them both out six months before graduation and signed up for the 10-year Standard Repayment Plan after your six-month grace period was up, giving one year for interest to add up on the Direct Unsubsidized Loan.

Here’s how the two compare:

Direct Subsidized LoanDirect Unsubsidized Loan
Balance after grace period$20,000$20,999.96
Monthly cost$212.13$222.74
Total interest cost$5,455.72$6,728.46

In this case, you’d pay $10 more per month and nearly $1,300 more in total interest because of interest capitalization.

How can I avoid interest capitalization?

There are a few ways to prevent interest from capitalizing on your student loans:

  • Go for the Direct Subsidized Loan when possible. Interest doesn’t capitalize during your grace period or deferment on these federal loans, making them the best deal available.
  • Pay interest while in school. If you don’t have a subsidized loan, pay off your interest as soon as possible — even if you can’t afford full repayments.
  • Avoid deferment and forbearance. While they might help in an emergency, these options add to your total loan cost and can seriously increase your monthly repayments. If possible, consider switching to a more affordable repayment plan instead.
  • Don’t switch out of an IDR plan or miss recertification deadlines. Leaving an IDR Plan adds to the total cost of your loan. It might be worth waiting until the balance is eligible for forgiveness at the end of the term.

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Bottom line

Interest capitalization is the reason why deferment, forbearance and income-driven repayments aren’t the cost-saving options they might seem to be at first glance. It increases both your monthly and total loan cost, and could make it more difficult to stay on top of your repayments if you were already struggling. You can learn more about how repayments work by reading our guide to student loans.

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